World oil market enters irrational territory

Animal spirits have taken over the futures markets of New York and London, with momentum-driven algorithmic traders and big hedge funds driving oil prices far beyond the point that even once-bearish analysts say is justified - at least in the medium-term - by supply and demand.Reuters | January 22, 2016, 14:02 IST

World oil markets quietly breached an important barrier as they crashed nearly 30 percent to below $30 a barrel in the opening weeks of 2016, crossing the fuzzy line separating a rational response to fundamentals from an irrational fear where the only way forward is down, down, down.

Animal spirits have taken over the futures markets of New York and London, with momentum-driven algorithmic traders and big hedge funds driving oil prices far beyond the point that even once-bearish analysts say is justified - at least in the medium-term - by supply and demand.

That marks a change from most of the past 18 months, when oil's long descent from $100 a barrel was broadly viewed as an often painful, sometimes lumpy adjustment to a fundamentally "new normal" in which OPEC would no longer restrain its supply, leaving US shale drillers to balance the market.

The process has taken far longer than expected as shale firms proved remarkably agile, slashing costs and drilling in sweet spots to keep the oil flowing.

As they did so, prices lurched lower, first in the summer and again this month.

But now things have gone too far, many say. Data due on Friday are likely to show that big funds and speculators in the US oil market added to short positions that had doubled to a record 200 million barrels over the past three months.

"The price itself is irrational if you ask me," Khalid al-Falih, the new chairman of the Saudi state oil company Aramco and one of the Kingdom's most influential energy figures, said at the World Economic Forum annual meeting in Davos.

"Prices are supposed to be set by the marginal barrel. The marginal barrel is certainly way higher than $30 a barrel."

The evidence of oil's unsustainable future at below $30 is mounting. US shale drillers are teetering on the brink of bankruptcy; Canadian oil sands producers are losing money with every barrel; heavy oil from Venezuela and Colombia is also underwater.

Few traders expect a quick recovery from this year's slump amid pressure from the deep supply glut and signs of economic weakness in China - the world's No 2 oil consumer.

Still, the evidence of oil's unsustainable future at below $30 is mounting. US shale drillers are teetering on the brink of bankruptcy; Canadian oil sands producers are losing money with every barrel as their crude trades at $15; heavy oil from Venezuela and Colombia is also underwater. Some $380 billion in oil and gas projects have been postponed or canceled since 2014, according to consultants Wood Mackenzie.

"It's not just the price, it's the incessant selling, every day. That surprised me," says Amrita Sen Chief Oil Analyst at Energy Aspects. "We are really in the realm of irrationality."

Not that the market has lacked excuses to sell: the rising US dollar; China's stock market meltdown; a vague worry that the diplomatic breakdown between Saudi Arabia and Iran had eliminated the already wafer-thin chance of an OPEC deal.

Some of them have been fundamental in nature - such as the warmest December weather on record and easing of sanctions on Iran - though neither should have been news to traders.

More likely is that much of the sell-off is driven by commodity funds who use algorithms to detect profitable trends - and often accelerate those trends at the extreme. Many programmatic traders fared far better than human fund managers last year, industry sources have said.